Wednesday, June 18, 2014

The AQM, Part 2: What does it mean to filers?

In the first part of this two-part discussion, we reviewed what the U.S. Securities and Exchange Commission (SEC) Accounting Quality Model (AQM, or "RoboCop") is using to evaluate public filings. The AQM was designed to help automate and streamline the review process of the eXtensible Business Reporting Language (XBRL) instance document, the machine-readable version of a filer's quarterly report.

Additionally, we looked a little deeper at how discretionary accruals are typically used to assess the probability of "earnings management". This can be problematic as it can lead to false positives, so the SEC is trying to shore-up this process by further by parsing discretionary accrual factors. They do so by categorizing them for deeper analysis as either factors that indicate earnings management and those that induce earnings management.

The real question is, what does this mean to individual filers? Here are a few thoughts for consideration:

The AQM has been in use by the SEC for close to a year. Soon after a filing is uploaded to the SEC's Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system, it is now processed by the AQM. Each filing then gets assigned a risk score which the SEC will use to prioritize its investigations and review efforts on filings most likely to show earnings management.

The SEC is in theory getting better at finding filers who use creative accounting practices. They now seem confident that they have good proxies for discretionary accrual factors. An example from the SEC’s Craig Lewis, recently retired Chief Economist and Director of the Division of Risk, Strategy, and Financial Innovation and chief architect of the AQM: “An accounting policy that could be considered a risk indicator (and consistently measured) would be an accounting policy that results in relatively high reported book earnings, even though ﬁrms simultaneously select alternative tax treatments that minimize taxable income.”

Because the SEC is using XBRL data, filing accuracy could save you a lot of potential hassle. From Craig Lewis’ Q&A with Merrill Compliance, “If you make a mistake in how you record an element, that would affect the score you get from the model and might make you more likely to be pulled up for a review—I would argue, correctly so.”

The SEC’s approach is not just isolated to the data in your filings. They have been developing ways to parse and analyze the reports included in filings as well.

What do you think? Have you seen that the AQM has been effective so far, since its implementation last summer? As an investor, does the use of the AQM give you more confidence in the electronic data being filed with the SEC? What other thoughts about the AQM would you add to this list?